Computation of damages and the incidence of tax

The recent decision of the Court of Appeal in Capita Alternative Fund Services (Guernsey) Ltd v Drivers Jonas considered a peculiar set of circumstances in which the incidence of tax can be factored in when computing the damages suffered by a commercial party. The House of Lords had considered this question almost 60 years ago in BTC v Gourley, and laid down a set of guidelines to determine situations in which tax implications could be considered when making an award of damages. However, the category of cases considered by Gourley and its progeny was one in which the damages awarded to the claimant are subject to no tax or a different level of tax. In such circumstances, Gourley held that the award of damages could be reduced to take into account the favourable effect on the claimant of the tax provisions. However, Capita v Jonas dealt with an entirely different situation where the tax effect did not act on the damages being awarded but was material to the assessment of the loss suffered. The Court of Appeal was therefore called on to consider whether the Gourley guidelines applied in these situations too, and if so, whether this was an appropriate case for them to be applied.

The claimant was a trust acting as an investment fund and intended to purchase some property as an investment. The defendant (which was a firm of chartered surveyors and property consultants) had been retained to advise on this transaction and value the property. The claimant determined the price it would pay to purchase the property based on the defendant’s advice, only to discover later that it had paid in excess of market value. It alleged that this disparity was attributable to the defendant’s negligence and entitled the claimant to damages equalling the difference in value. The defendant denied liability and also challenged the quantum of damages.

The trial judge upheld the claim, and the defendant appealed on three grounds: (i) even if there was negligence, no loss had been established; (ii) the judge had not considered the tax effect of the transaction on the claimant in arriving at the quantum of damages; and (iii) the interest calculation was incorrect. Of these, only the second ground is of interest for the present purposes.

It was significant for this case that the claimant was a trust acting as an investment fund, and that due to the regulatory regime, the individual investors in this fund obtained tax credits as the result of the trust’s investment in the property. It was also important (and common ground) that any damages awarded to the trust as a result of this claim would be held by it on trust for the individual investors. However, the defendant’s contention that the tax credits which the investors would get from the investment had to be reduced from the purchase price of the property, was rejected by the trial judge on two bases: first, the tax credit in question in effect required the investors to retain ownership of the property for 7 years; secondly, it was not appropriate to reduce the tax credit only from the purchase price without also deducting it from the market value of the property. Therefore, not only could the tax credit not be taken into consideration, but even if it was, the effect would be lesser than the defendant contended. The trial judge also noted the principle in BTC v Gourley, and pointed out that this was not a typical case in which the Gourley principle applied.

On appeal, the claimant reiterated the trial judge’s reasoning and also argued that the individual investors in the trust were different from the entity claiming the loss, i.e. the trust; and that it was incorrect to ignore structures deliberately chosen by parties for a particular transaction. Also, the losses suffered had been calculated on the basis of the ‘diminution in value’ approach, which assessed the losses as on the relevant date. Factoring in tax credits which would be realised only if the property continued to be owned for 7 years would violate this principle of computing damages. However, Gross LJ in the Court of Appeal rejected these arguments and partially upheld the defendant’s contention- holding that the tax credits had to be deducted from both the purchase price and the market value of the property.

It is interesting that the defendant’s case was put not as a reduction in the purchase price of the property due to the tax credits, but as an increase in the market value of the property because of the availability of the tax credits (the net result remaining the same). The defendant contended that in determining the purchase price, the ‘whole’ of what was bought had to be looked at, and in this case, the ‘whole’ referred to the property along with the tax credits. Accepting this contention, Gross LJ observed that it was “unreal to ignore that, on making the investment, investors immediately, or almost immediately, became entitled to the tax credits already mentioned – so in practical terms reducing the purchase price; put another way, the “whole” that was bought included the tax relief”.

Going further, Gross LJ directly applied the Gourley principles to these facts, without endorsing the trial judge’s circumspection about extending Gourley. It was evident that the tax considerations were integral to the investment, and ignoring them would leave the calculation of damages out of touch with reality. This did not mean that the incidence of taxation must be taken into account in each claim of damages, but when tax considerations are “part and parcel of the scheme”, it would in principle be wrong to ignore them. Therefore, on the basis of the guidelines laid down by Gourley, Gross LJ concluded that the amount of damages awarded had to be reduced by factoring in the effect of the tax credits. However, this would not have the effect of simply reducing the damages awarded by the amount of the tax relief, since the tax credits would have to be deducted from both the market value and the purchase price. Therefore, while the damages awarded would be reduced, the reduction would not be equal to the tax credits claimed. As to the contention that the credits in effect required the property to be held for 7 years, Gross LJ observed that irrespective of this requirement, the investors nevertheless had the “more or less immediate ability to obtain relief on making the investment”.

This is an interesting example of the interplay between the computation of damages and the tax effect of transactions; emphasising two main principles of broader application:

• The Gourley guidelines are not restricted to cases where the award of damages itself has a favourable tax effect, but also apply to cases where the tax effect is to reduce the quantum of the losses actually suffered; and

• In cases where tax consequences form an integral part of a transaction (in particular in determining the value of a proposed investment or assessing its profitability), these tax benefits may be ‘added on’ to the market value of the investment in determining the quantum of any damages awarded for the negligent valuation of the investment.